The Price Elasticity of Demand of Australian Urban Residential Consumers and Water Restrictions

The aim of this article is to provide derived estimates of the price elasticity of demand for water for residential urban consumers in Australia over the years 2005/06 to 2016/17. The results of the study indicate that higher water and sewerage prices, bundled together, are associated with lower demand for water. The relationship, therefore, between the prices of water and sewerage and demand for water is a negative one. This relationship, however, is a relatively inelastic one, that is a large change in price is required before there is much of a change in demand for water. With the supply of water in most Australian urban centers are controlled by monopoly suppliers this means that there is some scope for water restrictions to negate this market power.


Introduction
Water is a vital element of life and plays an essential role in economic development. Water is also a scarce resource and it is essential that water prices are a reflection of the cost of extracting and delivering it to consumers, in order that water supply and sewerage disposal infrastructure assets are used efficiently, and so that funds can be raised to finance improvements and extensions to the infrastructure. Water prices, therefore, must be high enough to provide businesses (and their owners) with a reasonable return on the funds invested in the assets. At the same time water is a necessity for all, and its use has environmental impacts, pricing therefore, is problematic given the political and social impacts.
In recent years the difficulties with ensuring a sustainable supply of water for Australian urban centers has been an important issue of economic and political concern. In response to this concern a range of measures have been undertaken by governments at the national, state and territory levels, designed to cope with these problems. In doing so, the social, environmental and political opposition to the building of large water storage dams and reservoirs has meant that a range of non-traditional water sources have been developed (desalination and recycling plant), as well as investment in water transmission pipes between regions. In addition, measures have been undertaken such as the creation of more commercial organizational structures to undertaken the deliver, and disposal, of water in order to improve operational efficiency. Finally more use has been made of pricing mechanisms to influence water demand.
In influencing the demand for water traditionally the measures that have been used most have been voluntary and mandatory water restrictions. Australian urban residents have been the subject of periodic water restrictions since the 1920s (Cathcart, 2010). Over time the increasing availability and affordability of domestic appliances, such as dishwashers, evaporated water cooling systems, and automatic washing machines has contributed to an increase in average water use. In the post-Second World War period rising levels of income, home ownership, and motor car ownership rates also contributed to a rise in demand for water (Morgan, 2011;Davison, 2008;Davison 2008). Water use restrictions were used, in this period, in a large degree, as an alternative to the substantial raising of prices, the latter being opposed for mainly political reasons. Water prices were also not used as historically water charges were based not on the use of water, but instead on property rating values. The replacement of this approach with ones based more on volumes consumed was a slow one, with the introduction of water meters so it could occur taking place at a varied pace across the country (Butlin, Barnard & Pincus, 1982;Byrnes, 2013;Industry Commission, 1992). Since the 1980s, however, water pricing based on volume use has become common in Australian urban centers.
Given the increased use of charging based on water use, the use of water restrictions and the restraints that exist on the supply of water in Australia it is important to understand the relationship between the demand by urban consumers and the prices they pay. When it comes to the pricing of the extraction and delivering of water there are two main components. First charges for water might be designed to only cover the current operational and maintenance costs of the infrastructure. This is considered a form of partial cost recovery. The second approach is to aim for charges that provide for a full cost recovery, which covers operational and maintenance costs, as well as yields a depreciation allowance and some net return on the historical capital costs.
The purpose of this article, therefore, is to derive estimates of the price elasticity of demand for water for Australian residential urban consumers over the years 2005/06 to 2016/17. The paper is structured as follows.
The first section provides a general background account of water pricing for residential urban water customers. This is followed by sections on the methodology and data used, as well as one that analyses the results of the study. In the final section some conclusions are made.

Background
Urban water is priced differently from most other goods given that it is largely provided by monopoly providers who can structure prices, largely immune from market forces. In addition, restrictions are used by government to control consumption in times of shortages. The use of restrictions implies that governments believe that water demand is market price inelastic, and responses to changes in prices take place very slowly. Water suppliers also have a restricted ability to respond quickly to increase water supplies when prices rise. The latter is largely true when water supplies are largely dependent on capital intensive, climate influenced surface water stores, but is less so with desalinated water supplies.
In the Australian case water usage prices have increased substantially over the years since the 1990s. From Figures 1 and 2 it is possible to see that in all the major cities in Australia water bills have risen since the early 2000s, both in normal and in constant $ terms. This has taken place for a range of reasons, including the increased desire on the part of governments to extract greater returns from water industry assets, as well as the need to pay for substantial investments on non-traditional water sources. It is expected that projected population growth, rising real incomes and a reluctance to build surface water reserves will put further pressure on supplies of water and lead to prices of water remaining high (Freebairn, 2008).
In recent years public authorities in Australia have focused on technological solutions to water shortages, such as the investment in recycling and/or desalination plant. This has meant that there has been a considerable level of capital expenditure undertaken by the water utilities in Australia. Figure 3 provides data on the level of this expenditure in constant $ terms. From this Figure it can be seen that this expenditure was greatest in the years 2006 to 2012, in a period of drought in Australia, and a time of substantially increasing prices (Figures 1 and 2) to cover the financing and to provide a return on this investment.
The increase in prices overall of water in Australia has led to a fall in consumption by Australia's residential consumers. Figure 4 provides data on the average annual water supply to residents in the major capital cities in Australia. As can be seen this has fallen from the high levels of consumption in the mid-2000s. This period, however, was also one in which water restrictions were used in various places, with various intensity, and so a part of this decline in demand for water would have occurred because of impact of these measures.    Over the period since the 1990s prices have not risen at uniform rates. Instead initially in some cities high prices were charged to commercial users in order to make up for losses, incurred on supplying residential customers (Productivity Commission, 2008). Community services obligations were also often incorporated into water pricing. Over time a number of these cross subsidies have been gradually phased out, changing the relative prices charged to different types of consumers. In terms of these different types of consumers, the structures of water charges still do rely on the type of property (residential, commercial of industrial). For residential properties that have water meters, most water suppliers levy an access charge based on the value of the property, which often allows the customer to an allowance of water on which no extra charge is levied.
There is a substantial difference between Australian water suppliers and jurisdictions in their structuring of urban water and sewerage prices. Table 1 provides data for the various urban utilities in Australia's capital cities in 2015/16. It can be seen from the data that both the average cost water and sewerage vary across the country. In addition, in some cases water rates are higher than sewerage rates (i.e. Queensland Urban Utilities, City West Water, and SA Water), while in others the reverse is true (i.e. Sydney Water, TasWater). In most Australian jurisdictions water prices are structured on the basis of a fixed access charge as well as a volumetric based charge (see Table 2). The use of the inclining block also differ (Crase, O'Keefe & Dollery, 2008). For sewerage most suppliers levy a single, fixed charge.
In Australia most urban water suppliers are state government owned, corporatized entities. Despite this state jurisdictional orientation they are the subject of a national approach to pricing. This has been so since 1994 when the Water Reform Framework was endorsed by each of the state, territory and national governments. The Framework included an agreement to introduce pricing practices that aimed to recover costs based on water consumption levels and was free of cross subsidies between different types of consumers. The Framework also included an agreement to establish two-part tariffs in urban centers where possible. Urban water reform was  Vol. 13, No. 3; extended with the 2004 National Water Initiative, which stated that water pricing practices be improved to better reflect costs (Council of Australian Governments, 1994, 2004. Water prices for urban water and sewerage in Australia today, therefore, cover operating, maintenance and administration costs, as well as any borrowing costs and to depreciation on assets/the cost of refurbishments. As well from 2004 onwards each jurisdiction became committed to having water pricing regulated by each of the state and territories' economic regulator.  Despite the introduction of cost-based pricing practices in Australia water use regulations and restrictions are still widely used. These restrictions are still often the response on the part of governments and water companies to urban water shortages. Despite this practice there is at present in Australia some interest in making use of more flexible water pricing in order to ring about a balance in demand for water with its supply. Whether using water usage prices will be effective, however, relies on water's price elasticity of demand (change in water demanded in response to a given price change). In addition, how long it takes consumers to respond to changes in water prices is also important.
The most frequent response of economists to water shortages is to advocate the use of water prices more strategically ( Barrett, 2004). Much has been written about the benefits of establishing water prices that reflect costs of the resource in alternative uses (Pawse & Crase, 2013). If efficient water prices are to be established it's important that a good knowledge of demand elasticities is achieved. Past Australian studies have provided estimates of this price elasticity to range between -0.3 to -0.5 (Productivity Commission, 2011;Sydney Water, 2011). Overseas studies come to similar results (United States, Environment Protection Agency, 2003). Using data collected by the Australian Government it is possible to derive demand elasticities for water in Australia's urban centers.

Method and Data
The method used is to run regressions estimating the price elasticity of demand with water consumption levels as the dependent variable and the price of water as the independent variable. The data set used is mainly based on the statistical reports published by the Water Services Association of Australia, the National Water Commission and the Australian Bureau of Metrology. This has been added to be additional statistical data taken from the annual reports of the water utilities. The water companies included in the study are listed in the table provided in the Appendix, along with the years for which the data was available. Descriptive statistics of the data is provided in Table 3.
As consumers are typically charged for water and sewerage services bundled together regressions are also run with the bundled price of water and sewerage and consumption of water. In addition other independents variables are used, such as the average rainfall and average temperature (data from the Bureau of Metrology) and the number of consumers (data from the National Water Commission).

Results
Multiple Regression: Dw=f(Pw, T, R, C) The initial regression has the consumption of water regressed to a number of independent variables. These include:  Dw: average annual residential water supplied (kL/property);  Pw: price of water in the locality annual bill based on 200kL/a -water ($);  T: average maximum temperature in the locality;  R: average rainfall in the locality;  C: number of consumers (population receiving water supply services -000s)

Model 1.1
To begin with demand is regressed with the price of water alone: The results are provided in Table 4. The R-square of 0.000 indicates that the water demand cannot be explained by solely water price, thus, the control variables such as temperature, rainfall, consumers are added in the model. The multiple regression model using the other independent variables is as follows: Dw =  0 +  1 Pw +  2 Temp +  3 Rainfall +  4 Consumers + ℇ R-square = 0.196 indicates that there is 19.6 per cent of the dependent variable that is explained by independent variables. The results are provided in Table 5.
In ANOVA and Coefficients Tables 6 and 7, the value of P-values of F-test and t-test are 0.000 which is less than 0.05. They indicate that there is a strong, significant relationship between the independent and dependent variables.
Dw = 283.804 -.124Pw + 1.618 Temp -0.029 Rainfall -3.139 Consumers + ℇ The results indicate that:  a higher water price, is associated with lower demand;  a higher temperature, is associated with higher demand;  a higher rainfall, is associated with lower demand;  a higher population, is associated with lower demand per person on average   In Australian jurisdictions although water and sewerage are generally rated separately consumers pay with their rates bundled together in a single bill. For that reason it is possible that demand for water is better related to changes in both water and sewerage charges. For that reason Model 2 includes both prices.
To begin with demand is regressed with the price of water and sewerage: The results are provided in Table 8. The R-square of 0.043 indicates that there is only 4.3 percent the dependent variable can be explained by the independent variables, however, the value of significance of F-test is 0.000 which indicate the model is significant (as seen in ANOVA table). The value of t-test of independent variables are significant that are very close to zero (as seen in coefficient Table 10). Dw = 230.209 + 0.067Pw -0.094Ps + ℇ This result shows that there is positive significant impact of water price on water demand, and negative significant impact of the sewage price on demand.   The multiple regression model using the other independent variables is as follows: The results are provided in Table 11. The R-square = 0.207 indicates that there is 20.7 per cent of the dependent variable that is explained by independent variables. This R-square value is acceptable since the unpredictable variables involved in the model such as temperature, rainfall, and population. In ANOVA Table 12, the value of P-value of F-test is 0.000 which is less than 0.05. It indicates that it is strong significant relationship between independent and dependent variables. In the coefficients Table 13, the significant value (sig.) of all independent and controlled variables are very close to zero, which means they have significant impact on water demand. The results indicate that:  a higher water price, is associated with lower demand;  a higher sewage price, is associated with lower demand;  a higher temperature, is associated with higher demand  higher rainfall, is associated with lower demand,  a higher population, is associated with lower demand per person on average.

Conclusion
The results of the study indicate that higher water prices are associated with lower demand for water. In addition, a higher sewerage price, is also associated with lower demand for water. The bundled prices of water and sewerage explains a greater change in demand for water than just using the water price. This relationship between the prices of water and sewerage on the one hand and demand for water on the other is a negative one. This relationship, however, is a relatively inelastic one that is a large change on price is required before there is much of a change in demand for water.
What this means is that there are a range of other factors that explain changes in demand for water besides just price. Those that were included in the model involve higher temperatures being associated with higher demand for water, higher rainfall being associated with lower demand for water and higher population meaning lower demand per person on average.
As water is a fairly strong necessity of life, demand for it is fairly steady and influenced by a wide range of factors. As water's price elasticity of demand (and sewerage's) is relatively inelastic, and as the supply of residential urban water is delivered by monopoly suppliers, there seems a firm justification by governments for making use of water restrictions. As market power is exerted by the water suppliers, and demand is price inelastic any use of substantial price increases to moderate demand for water, will more likely result in monopoly rents being extracted from consumers rather than any substantial moderation in demand for water. Economists who advocate further use of prices to moderate demand for water are probably under estimating the elasticities both of demand and supply of water. Further research on the nature of the price elasticities of both demand and supply for water would enable greater insights into the effectiveness of restrictions and water usage charges. Also research on other possible variables that impact on water demand would be useful.